EBITDA multiples are used to value or benchmark businesses. Unfortunately, the multiple changes with capital intensity, nature of the business, competitive
position of the firm, and sustainability of the cash flow. Like a chain saw,
EBITDA should have a warning label, “This tool can be dangerous if used improperly.”

Some operations managers like to use EBITDA as an internal metric which is under their influence. EBITDA is subject to GAAP guidelines, which means interpretation of how revenue is booked, etc. but management can get a sense of the “cash flows” available for debt capacity and capital expenditures. Some analysts like to be able to make comparisons using EV/EBITDA because this metric strips out debt, tax and fixed investment policies of the businesses they are comparing. These analysts feel that they are making more of a raw comparison.

But the value of a business depends on the amount of net cash you can receive from the business discounted back to today at your required rate of return plus the non-operational assets, so EBITDA can’t be used to determine intrinsic value.

Even though EBITDA can be misused, there are always problems with metrics like Price-to-earnings ratios (P/E) for example: with a forward looking numerator and a denominator arising from the past, is it any wonder that P/E ratios are faulty indicators of value?

You will understand after reading the lessons and listening to the lectures why comparisons like:

This company is “cheaper” because it trades at an EV/EBITDA multiple of five times compared to its peers that trade at seven times EV/EBITDA can be misleading.

OK, back to EV/EBITDA.

ENTERPRISE VALUE (“EV”)

To look at stocks as a business you must know the current price of the corporation or enterprise value.

Enterprise Value or the asset value of the company is the price you would pay for the entire business based on the current market price of the company’s share and net debt. This metric assumes that the worth of a company is the sum of all outstanding obligations (stocks, bonds, and debts) minus the cash the company has on hand not needed for the business operations. The formula is: EV = Mkt. Cap of equity + Preferred Stock + Debt – Cash Equivalents in excess of business needs for one year.

An excellent 15 minute video explaining the advantages of using EV and how to calculate EV is here:

Ignoring the capitalization structure (debt) of a company while just looking at equity market capitalization would be similar to a pilot ignoring a fuel gauge before takeoff. Click on this link to realize what can happen (go to 4 minute mark). http://www.youtube.com/watch?v=s_L6F2VIevI&feature=related

Comparing two companies with different capital structures; say one company has debt and the other has surplus cash and no debt using price earnings ratios would be misleading. Buffett and Graham say to look at stocks not as flashing prices on a green screen, but as businesses. To know what the market price of an entire business would be you must use enterprise value (“EV”).
Thinking inversely, you would realize that debt-free companies with no surplus (non-operational) assets like cash would have EVs equal to their market capitalizations; therefore, P (mkt. price x fully-diluted shares outstanding) = EV.

Once you embrace the metric of EV, you will understand the problems with using a price-to-earnings ratio which is calculated: the market price of the equity (market share price multiplied by fully diluted outstanding shares) divided by one year’s profit after tax or Earnings.

The Khan lecture on EV is nice. It would seem you could really improve your odds by using his simple rule of 6x operating income as being a decent price to pay for EV (and then backing out MktCap from EV to find price per share). This sort of fits with the 4.5x operating income multiple mentioned in Class #1 as being a REALLY attractive price to buy at – that’s 25% cheaper!

And of course we’d use normal EBITDA-MCX for operating income (not OI from the income statement).

I do wonder if franchise businesses ever get anywhere near that cheap. For example, KO currently trades at 23x EBITDA-MCX by my rough calculations.

Once the case studies for the additional videos are up I will spend A LOT of time on franchises. Read Greenwald´s book on Competition Demystified and Jarillo´s book, Strategic Logic. Two EXCELLENT books to understand franchises. Have your university library get them for you through interlibrary loan. I am sure you will want to buy them.

I agree that EV / (EBITDA – MCX) is probably the most accurate reflection of providing a multiple on unlevered free cash flow. However – why not just EV / EBIT? It takes care of the lack of treatment of D&A when using EBITDA (assuming that capex = D&A, which is usually pretty close most of the time), and the user doesn’t need to estimate what MCX for a business looks like. It’s not as perfect as EBITDA – MCX, but it sure as heck a lot quicker to calculate, and absent of biases.